In the past writings below, I referred to the concept of a fair value for stocks. However, I skipped a step. I did not define what I meant by fair value. So here goes…

To start, let us assume that we are not in extraordinary times (link). Assume that we are in normal times, that the economy is fine.

The first concept is the Price/Earnings ratio. It compares a stock’s 12-month trailing earnings over the current price. For example, currently a major U.S. car company’s P/E is 12x and a cell phone equipment company is 18x. The P/E difference is due to the expected future earnings growth of the cell phone company being higher than the car company’s. Therefore, the higher the future prospects for a company, the higher the P/E ratio of its stock.

Next is the PEG ratio. The PEG ratio is the P/E ratio over the expected growth rate in earnings. A company that is 15x earnings which is expected to grow earnings at 15% has a PEG ratio of 1 (This is considered fair value, some would argue for a higher number). Below 1 (or 2), the stock is cheap, above …expensive. Yahoo finance is an excellent webpage to find this out and more on almost all stocks.

Lastly, because earning can be volatile, a leading economist, Robert Shiller developed the Cyclically Adjusted Price Earnings ratio (CAPE10). This ratio is based on average inflation-adjusted earnings from the previous 10 years instead of just the last trailing 12 months. It is believed to be a more accurate measure.

Of course, due to a cornucopia of various factors, the CAPE10 ratio is a poor predictor of short-term movements in stock prices (and there is certainly no shortage of various factors lately). Lazlo Birinyi well documents this (he continues to call for higher prices). However, over the longer term, I believe the inevitable gravity of fair value pulls on prices (link).

There’s a great scene in Jurassic Park where Alan, Tim and Lex watch a stampede of dinosaurs suddenly change direction and head right toward them. What made them change direction? What made them decide that this new direction was any better?

Turns out investors do the same thing, just with their investments. As they sense other investors moving into the market, they follow. As investors move from bonds to stocks, others follow. There is a perception that there is safety in numbers. Both dinosaurs and investors tend to act as “herds”.

Problem is that it’s a misperception. Following the herd can cost investors in the end.

Remember to stick to your investment strategy and don’t follow the heard… they could be headed for a cliff and not even know it.

Stock market crashes and big economic recessions can be caused by a variety of factors. The real concern are the factors that seem to come out of nowhere; the ones that catch everyone, even the experts, off guard.

Take all this talk by the media predicting an economic downturn with a grain of salt. It’s next to impossible to predict events such as the Great Depression or the Great Recession of 2008-2009. Up until 2008, had you ever heard of a Mortgage Backed Security?

Bottom line: Your portfolio should be ready for anything at any point in time.

With the equity markets reaching all-time highs, you would think everyone on Wall Street would be dancing in the streets. Nope! They’re using this time to talk about all the reasons why we’re in for a big correction, down turn, or crash.

This shouldn’t be a surprise. It’s never clear sailing when it comes to investing. There will always be issues that make investors nervous. And the markets will always experience recessions.

But investors might forget that the markets do this funny thing when everyone is expecting the market to rise (or fall)… it might just do the exact opposite of what we expect. Despite all of the expert opinions and the number crunching, there will always be the human equation to factor in and that’s hard to capture. Perhaps all this fuss is just noise and the markets will continue to climb.

Bottom line: Your portfolio should be ready for anything at any point in time.

Much of the attention over the last few months on the effects of interest rates and bond tapering on your portfolio focus on the immediate consequences – a decline in bond values. But rising interest rates can be good for your portfolio over a longer time period due in part to reinvesting interest income. Not to mention, it is a strong signal that the US economy can come off of life support. See the chart for details.

So why did investors leave bonds during this summer? Could it be that investors are afraid another recession is around the corner and don’t have confidence in the markets? Perhaps they are looking for a reason to sit in cash willing to wait for more clarity to come from the Fed.

That could be a costly mistake… just ask those who are sitting in cash since the Great Recession.